Floating rate loan funds are a relatively new and as yet unheralded concept
in retail investing, with only a couple of the 15 funds in the category
having a 10-year history. But with interest rates now on an upward
trajectory (and equity markets seemingly in retreat), they’ve begun to
attract considerably more attention. In fact, the category’s performance in
recent months has been near or at the top the fund listings.

So what exactly are floating rate loan funds? According to the Canadian
Investment Funds Standards Committee (CIFSC), funds in this category must
commit to investing at least 25% of their portfolio in non-investment grade
(lower than BBB or equivalent) floating rate loans.

“These loans are not registered securities, they are syndicated bank
loans,” says Kevin Nielsen, a portfolio manager in the high-income division
at Fidelity Investments in Boston, MA, and co-manager (with Eric
Mollenhauer) of the FundGrade A+® Award winner
(2016)
Fidelity Floating Rate High Income Fund. “You can’t just go out and buy them on your own. “It’s a very different
asset class, one that has grown pretty quickly in the past few years.”

Neilsen explains that usually lenders (in this case commercial banks) would
tap other banks to syndicate the risk on large loans, but in recent years
that net has been cast further and further afield. “If the bank extended a
$100 million loan to a widget company, for example, they would go to other
banks to spread the risk. But then gradually they started going to
institutional investors, and now they’re in mutual funds.

“The structure of these loans is similar to other fixed-income investments
such as bonds,” says Nielsen, “but the unique part is the floating rate on
the coupon. It’s not fixed, but rather is indexed to LIBOR” (the London
Interbank Offered Rate, a benchmark representing the average interest rate
at which banks lend funds to one another, and calculated daily from
estimates submitted by leading global banks).

So, for example, at press time LIBOR was 270 basis points, or 2.7%,
according to Nielsen, and the spread was 330 basis points (3.3%), so the
average yield would have been 6%. “The spreads do move, though. For
example, during the financial crisis the spread went to 5%. When the
markets are doing better, the spread gets smaller.

“Obviously, the issue of supply and demand can also drive prices and impact
returns, but the coupon helps to offset some of the price volatility,”
Nielsen adds. “And the floating rate takes away some of the interest rate risk when rates
are rising. This feature has put us in the spotlight as investors start
looking for protection
.”

In terms of actual holdings, the CIFSC mandates a minimum BBB rating, but
Nielsen says their fund’s holdings average around B or BB. “The high single
Bs are most interesting, because they are the most difficult to rate
accurately,” he adds. “People misunderstand them, but if you do your
homework you can beat the competition by picking up companies that are
rated worse than they should be and avoiding companies that are overrated.

“Of course, if you get it wrong, then you can go to zero,” Nielsen adds.
“But if you can avoid companies that get into trouble, that’s 80% of the
battle. “It’s the ones that get into trouble that can damage your returns.”

And how much can you expect by way of returns? The Fidelity Floating Rate
High Income Fund boasts a 5-year average annual compounded rate of return
of 7.5% to Oct. 31, 2018 (the floating rate category average was 5.5%), and
4.8% for the most recent 12 months (3.1% category average). Those aren’t
bad numbers, considering the alternatives. “It’s been a good asset class
for the past few years, with low volatility even compared to
investment-grade markets,” says Nielsen.

Olev Edur
is an experienced financial and business journalist and a frequent
contributor to the Fund Library.

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